Ignore the ‘30 Percent Rule’ When It Comes to Rent

This is part three of an ongoing series about housing costs. Check out part one and two on our blog.

Ever heard of the 30 percent rule? It’s the idea that you should budget a maximum of 30 percent of your income for housing costs, and it’s practically personal finance gospel.

Affordability calculators often use it as a default assumption to determine how much house you can afford; mortgage lenders have adopted it as a qualification ratio when approving you for a loan; and private landlords often require tenants’ annual salaries to be at least three times the monthly rent.

But who exactly is following this rule? And does it make good financial sense to do so?

To address the first question, Earnest took a look at our dataset of more than 15,000 student loan applicants.1 We found that at salary levels below $30,000, spending above 30 percent of gross income on housing is the norm. (This is supported by a recent Harvard report, which found that 45 percent of households who make $30,000-$45,000 have rent costs above 30 percent.)

At incomes above $30,000, however, Earnest applicants increasingly spend less than the benchmark — down to around 10 percent of their gross incomes for the wealthiest renters. This reflects the economic idea that a person’s marginal propensity to consume generally decreases with increasing income. In other words, if your income doubles, you’ll likely start spending more, but not a full two times more.

Among Earnest’s loan applicants, people making around $30,000 happen to be following the 30 percent rule, but generally, most people are paying much more or much less.

So, should the 30 percent rule even be a rule at all? To answer that question, we turned to experts David Bieri, an associate professor of Urban Affairs at Virginia Tech, and Carrie Friedberg, a San-Francisco based certified money coach.

The short answer: No. Here are three reasons why.

1. It’s outdated.

The 30 percent rule has roots in 1969 public housing regulations, which capped public housing rent at 25 percent of a tenant’s income (it inched up to 30 percent in the early 1980s). Rather than looking at what consumers should be spending on housing, however, the government selected the percentages because that’s what consumers were spending.

“This is what one did on average in the past, and as such [the benchmarks] become absorbed into public policy,” says Bieri, who has written several papers on the subject.

Bieri sees two problems with making 30 percent the de facto personal finance rule for renters: First, averages, by definition, do not take into account the huge variations of what individuals do. Second, the balance sheet and financial obligations of today’s consumers are vastly different than those of the 1960s on whom this rule is based. Americans back then, for example, didn’t contribute to 401(k) plans or have high student debt.

2. It ignores other financial factors.

Let’s do some back-of-the napkin calculations. Say you’re making $30,000 per year and have no household debt. According to the 30 percent rule, you’d be able to spend $750 per month on rent, which would leave roughly $1,300 a month for savings and expenses (or $325/week, or $46/day), after taxes. Sounds great — until you start subtracting student loan payments (income-based repayment plans typically cap them at 8-10 percent) and retirement savings (ideally 10-15 percent). All of this could subtract another 15-20 percent, without accounting for food, entertainment, transportation, child care, additional debt or other savings.

And if you’re making $300,000 per year? The 30 percent rule would prescribe spending $7,500 a month on rent. Friedberg says even high earners may have debt, child support, alimony, elder care or other substantial expenses — like saving for retirement. And in the long run, paying 30 percent on rent may be an irresponsible practice.

“High earning individuals with a passion for their job and a commitment to their location might consider making a better investment in [buying] a house, condo or an apartment,” says Friedberg.

3. It’s not applicable to everyone.

Last but not least, as Bieri pointed out, all renters’ needs are not alike. Young, city-dwelling professionals with an active social life might not need or want more than a conveniently located small, two- or three-room apartment they can share with roommates, for example. Contrast their budget to that of a young family (who might have the same income as the professional roommates) looking for space for children and willing to pay a premium to be near good schools.

So what’s a better rule of thumb? Instead of blindly following the 30 perecent rule, create a realistic budget (start with an online tool like Mint.com or MoneyMinder.com) tracking all of your current expenses to see how much is left over for housing. “When you have a thorough picture of your financial life, you can run various scenarios to determine how much you can afford to pay,” says Friedberg. “There is no magic, one-size-fits-all answer.”

For earners who are able to save, Bieri recommends using a different benchmark altogether: the three-month emergency fund. Look at your cash flow and liquidity, he suggests, to calculate whether you have enough of an emergency account to cover three to six months’ worth of rent and debt obligations if you were to lose your income. The math may be trickier, but you’ll have a much clearer sense of how much rent you can comfortably afford.

1.Data reflects applicants aged 18-34 who applied for an Earnest loan with rents of $100 or more and incomes of $1,000 or more.